Habitual skeptic

Category Archives: Money

Bitcoin & other cryptos have taken a sharp nosedive of ~33% from peak. Although it may rally short-term, let’s take a look at the internals of what’s going on and where this is all heading.

People are parking Bitcoin profits on Bitfinex (biggest bitcoin exchange) into tethers, the fake token people think has 1:1 USD backing (but doesn’t). Tether will push the printing press into overdrive to try to pump Bitcoin price once again.

If this fails, there will be a run on Tether as people try to realize profits in USD. This can’t be done — the money isn’t there. At that point, holders of Tether have only one choice: buy crypto, anything, and try to transfer out to exchanges that support USD withdrawals (Bitfinex does not).

This could be the biggest spike crypto has ever seen. It’s uncertain which cryptos will spike most. For example, Bitcoin has well-known transaction problems, so would not be the transfer mechanism of choice. Probably Bitcoin Cash would be preferred, since that is relatively fast, cheap, & supported on GDAX (USD exchange).

That would mean the evisceration of the Bitfinex exchange and a sharp drop in aggregate trading volumes. The owners may opt for a big gamble to retain their profits — look for claims of a huge “hack” on Bitfinex. This lets the Bitfinex operators steal customer funds before the collapse, Mt Gox style. An alternate scenario is a “hack” on Tether to prevent a run on Tether in the first place. This actually happened about a month ago, 30 million Tether stolen, from a 3/4 multisig wallet (likely inside job). Something of this magnitude may trigger government involvement.

If the crypto in Bitfinex does make it into the other exchanges, you’ll see the huge spike I mentioned. But, since Bitcoin price will now be un-tethered from the Tether printing press, it will be very short lived and collapse once former Bitfinex customers try to realize USD profits. Then Bitcoin could fall way below the levels we are seeing today.

A common argument for the unique value of bitcoin is its hash power, meaning the amount of computational power (miners) dedicated to mining bitcoin. But, with merge mining, another blockchain can potentially capture the entire hash power of bitcoin with no impact on bitcoin’s network. That means that, although independent cryptos may eventually be swamped by a bitcoin monopoly, the value of bitcoin will be diluted by other chains piggybacking on its network.

The way bitcoin is mined is by miners “hashing” the existing blockchain with a random number. Hashing is a one way function that takes in some content and spits out a result. If the result meets certain “difficulty criteria”, it is accepted by the network and the miner is rewarded a coin. It is impossible to ever derive the original content from the result, which is why it’s called one way.

Merge mining works by combining the random number guesses from one chain, with those from another chain. The result will be valid on both chains. If it meets the criteria for both chains, the miner will get rewarded for both. The miner loses nothing by mining both, but gets more reward.

The economic effect of this is to increase the miners available to mine alternative chains. Since profits go up, the number of total miners goes up, which will push profits for a particular chain down. This should mean lower transaction fees for any particular chain. It also means that no chain holds a monopoly on being a transaction mechanism.

The lack of a potential monopoly means that bitcoins should be treated as a competitive payment mechanism, instead of as a monopoly. Many coins will be able to process payments, with the same hash power, even if most miners mine the bitcoin chain. Some may be superior to bitcoin in their payment processing capabilities.

Bitcoin fanbois point to bitcoin’s utility as a payment network. But, unlike Visa, holders of bitcoin don’t get any of the mining revenues, so there is no revenue stream on which to value a bitcoin.

Participants do need to have bitcoin to transfer funds, but they don’t need to hold it for longer than the transaction itself. Since bitcoin is limited to ~3 transactions per second, and average confirmation times are several hours, depending on network congestion, there is no need for more than a few bitcoin to accomplish all payments across the network. As an example, assuming 1 bitcoin per transaction, 3/sec * 3,600 sec/hr * 3 hr/confirmation = 32,400 bitcoin to execute all payments on the network.

Also, since bitcoin can be divided into satoshi, hundreds of millionths of a Bitcoin, there is no need to hold a particular amount of bitcoin to accomplish a transaction. The bitcoin itself just represents the transaction record, not the value of the contract, just as a record in Visa’s database represents the transaction, and is not in and of itself valuable, beyond the market price of the transaction mechanism (about 1%).

Even if holders of bitcoin shared in the mining revenues, the competitive mining market produces a flat fee per transaction, not a percentage fee, which allows the transfer of massive fortunes for a tiny fraction of a percent. It would be a much worse value proposition, for investors, than Visa.

The fiat price of a bitcoin arises from an artificial restriction on bitcoin supply & mining, and people’s expectation that these restrictions will entice others to buy their bitcoin in the future at a higher price. The “greater fool” theory. But this is separate from bitcoin’s utility as a payment network.

It is no different from other speculative phenomena such as Beanie Babies, baseball cards, and other artificially restricted commodities. People misinterpret the restriction as an ipso facto justification for a high price. Once all available cash & credit has poured into the commodity, there are no further buyers, the mania ends, and the price drops to the utility value of the commodity. In bitcoin’s case, its utility value is close to zero.

If they keep printing, the gap widens and they have to redeem more and more tethers for USD

At that point, the game is up and Tether will have no incentive to continue redeeming tethers. The tether market collapses. You can redeem 1 USDT for 1 cent. BTC paper profits are wiped out. Tether is left with >600 million USD in the bank.

If you were an account holder, what would you do? I’m not able to withdraw my USD. Therefore, I’ll buy BTC so I can move it to another wallet. Hence, increased demand for BTC on their exchange, and increased price AND volume.

Other exchanges did the same; there are not many that allow USD deposits & withdrawals now.

This recent BTC price increase is caused by the fact that no one can withdraw USD!

What happens when this bottled-up demand to withdraw finally moves into USD, other fiat, or other crypto?

The strength of a cryptocurrency is the share of global processing power it can muster in service of its ledger. An attack by a significant computational resource (botnet, mining pool, government supercomputer, etc.) could potentially reverse recent transactions or cause a fork of the currency. The reason the global share matters is that computational power is fungible, and may be used in service of any cryptocurrency.

The less computational power dedicated to mining a crypto, the more vulnerable it is to attack. Alt-coins that do not command as much hash power as Bitcoin would be first in line.

Processing power over time is governed by the price per computational unit and by the price of electricity. For example, a spike in electricity prices or transistor prices would increase mining costs, and therefore transaction fees, possibly disrupting the usability of the currency. A sudden drop in electricity prices or transistor prices would reduce mining costs, increasing the chance of attacks on a currency’s ledger.

Such attacks could be orchestrated, not necessarily to steal the underlying wealth of currency holders, but to accomplish secondary effects beneficial to the attacker. For example:

A large investor in a particular crypto may attack a competing (smaller) crypto intruding in the space. This implies a first-mover advantage in the cryptocurrency space and stratification of crypto, with one per defensible economic niche. Eventually, the market may consolidate into one global crypto.

Momentarily disrupt the functioning of a crypto at a critical moment in its development, for maximum PR effect, to spread fear & uncertainty to potential investors and adopters.

You would only need to bid on computing power for a short time to cause a major disruption. Miners are very sensitive to transaction fees, so would quickly respond to any change in market demand. Furthermore, cloud mining operations, and cloud computing in general, provide an easy way to quickly spool up computing power for a short time, disrupt the target crypto, and spool down, thus minimizing costs.

Alt-coins based on a permissionless, global blockchain are very vulnerable to this type of attack. Eventually, even Bitcoin itself may come under attack should there be a revolutionary development in computational hardware, exploited by a group of early adopters, or a government willing to throw massive fiat to kill it once and for all.

All “cryptocurrencies” based on artificial limits are inherently pump-and-dump schemes. If they were true free market currencies, the money supply would grow with demand. Instead, they are artificially restricted. Why? To create the illusion of limited supply and therefore expectation of future scarcity and speculative profit.

They are fiat currencies, based on nothing but this speculation. The Bitcoin price chart shows this. Bitcoin fanboys point to the skyrocketing price as a badge of honor, but all it shows is that it is a speculation, not a store of value. It has no price stability, and cannot be considered a “currency”.

In the short term, the price will keep going up for various reasons. Mining is getting more expensive and less profitable, driving out miners and restricting supply. Use as a pseudo-anonymous money transfer scheme is increasing on the dark web. A method of circumventing Chinese capital controls. An investment vehicle for Chinese with not enough local investment options.

But eventually, people will realize NOTHING holds up the value of Bitcoin. No petrodollar, no USG taxation. And it will collapse, as will the rest of the currencies that will inevitably fork off this one. This is even ignoring the major security and regulatory issues that plague Bitcoin.

Currency is a form of social credit. It’s an implied debt, that someone will pay off with goods & services in the future. This should be the basis of any cryptocurrency, not arbitrary and artificial limits on supply, and fancy math for its issuance.

This post is an edited collection of my responses to James Corbett’s interview of Ken Shishido on Bitcoin.

Bitcoin was an interesting experiment in digital currency, and there will be many more, with improvements. It is definitely not a real currency though. The recent Bitfinex hack, wiping out 36% of account balances, on top of many previous hacks, show it’s less safe than even a fiat bank account.

Ken Shishido’s recommendation to put into Bitcoin “what you can afford to lose” is a reminder that it’s a speculation, not money. Still, it’s definitely worth keeping an eye on developments with blockchain technology and new Bitcoin-like instruments that perhaps address the past issues with Bitcoin.

Bitcoin, exchanges, and security

Some make the distinction that hacks have targeted exchanges or warehouses, not Bitcoin itself. While the distinction between Bitcoin itself and exchanges or warehousers is important, the average person trying it out won’t necessarily understand this or its security implications. To them, the end-to-end process constitutes the solution, and most likely that will include an exchange.

You can get Bitcoin either by mining or by buying them on an exchange. Since mining is now incredibly expensive and technically challenging, the vast majority will buy on exchanges, which is a security risk, even if you don’t warehouse your bitcoin. In addition, most retail merchants accepting Bitcoin immediately liquidate receipts into dollars, making much of the market value of Bitcoin dependent on exchanges.

Even if you avoid exchanges altogether, you are still affected by these hacks. Since Bitcoin’s value depends so heavily on exchanges, a loss of confidence leads to a massive loss of value in the currency itself. This indeed happened after the Bitfinex hack.

There are also issues with the security of storing Bitcoin yourself, of transmitting them, the questionable privacy of a public transaction ledger (blockchain), and many other issues that the average person frankly will not understand or have the time to study. For the average person, the most secure currency is paper dollars, or gold/silver as a small inflation hedge.

There’s a lot of potential in cryptocurrency, both on the central bank side and the peer to peer side. I just don’t think Bitcoin is a particularly good solution, except maybe in certain use cases like international money transfers, that are plagued by high fees. But it’s a lot less than its hype.

Inflation Hedge vs Paper Money

One hundred billion mark note, Weimar Republic

In comparing Bitcoin to fiat or paper currency, Bitcoin advocates point to the inflationary history of paper money and its control by central banks. However, most modern currencies do not hyperinflate. Zimbabwe, Venezuela, the Weimar Republic, etc. are outliers due to unique political circumstances. Of course, that may change and eventually the US dollar will hyperinflate and collapse. But the key word is “eventually” – it may not happen for a very long time (or it may happen next year).

There are three things working against a dollar collapse, no matter how much they try to destroy it: 1. the oil market is priced in dollars, 2. it is required to pay US gov’t, fed./state/local taxes, 3. it is legal tender for the private US economy. So we’re talking about a backstop of many trillions of (current) dollars in value, something no other currency or country can match. So it’s unlikely to “collapse” anytime soon.

If we talk about collapse, Bitcoin lost 80% of its value in 2015, then recovered a bit, then recently lost 25% of its value. That’s a much bigger loss of value than is likely in the dollar, whose deprecitation is pretty stable over time. Bitcoin’s price may stabilize later on, but it’s not ready for prime time and definitely not a stable store of value.

Anyway, let’s be real. For most people these currency hedges don’t matter, because they don’t have much money to begin with. Liquidity is more important, to pay the bills, so dollars (or your local currency) are best. If you do have a lot of money, then sure, have some small hedges with precious metals, a little with Bitcoin, maybe some art, etc. They all carry their own risks. There is no such thing as a risk-free store of value.

UPDATE 08/19/2016: Bitcoin.org has warned that the code for Bitcoin itself may be hacked by government agents. Not even the currency itself is entirely secure!

I hear this argument in most critiques of the Federal Reserve, so it definitely needs to be addressed.

Talking to an anti-Fed person, you may have heard something like “The Fed is terrible, it controls all our money. And did you know it’s private?!”

The implied or stated proposal being that government should take over the money-printing. But it’s not the fact that the Fed is partially private that’s the problem – it’s the fact that it’s partially government! What’s bad about it is that we’re all forced by law to use their currency. It is a legal monopoly on money, for which there is no ethical justification.

From a voluntary ethics standpoint, no one should be forced to use or not use any money, or prohibited or compelled to issue money. But even from a utilitarian view, a government takeover of money would not be a very good safeguard against monetary inflation. Historically, governments have debased their currencies as a means to finance their grand schemes, variations of bombs or bread. Can you imagine what Congress would do without the admittedly weak restraint of the Fed? They’d spend into oblivion, even more than now, and destroy the dollar in the process!

The real answer is – eliminate the Fed’s legal monopoly on money. Let them be a private bank competing in a free market. Of course, they probably would go out of business, but hey, that’s free market capitalism!